RBI shifts focus to headline inflation

In a surprise move, in its mid-quarter monetary policy review, the Reserve Bank of India (RBI) left repo rate and CRR unchanged. The central bank believes that interest rates are only a small factor in the current economic downturn, and worries that supply bottlenecks and sticky inflation expectations are keeping up headline inflation.

In Edelweiss' view, RBI has already succeeded in curbing demand-led inflation, and the economy has slipped far below potential. In such a scenario, keeping policy tight to address headline inflation could prove counterproductive. Fiscal deficit would worsen further (as tax revenue falters due to weakening growth), investment slowdown would deepen and inflation could remain sticky (due to lack of capacity creation). Accordingly, in their view, Mint Street should undertake about 75-100bps easing in rest of

FY13.

RBI surprises with status quo on rates…

RBI, in its June 2012 mid-quarter monetary policy review, maintained a status quo on repo rate and CRR (8.0% and 4.75%, respectively). This move was in contrast to their and market expectations of 25bps reduction in policy rates. The rationale for the status quo is that rising inflation (both WPI and CPI) is having a bearing on sticky inflation expectation and that interest rates have only a small role in slowdown of activity, particularly investments. Accordingly, RBI stressed that reducing policy rates at this juncture would not support growth, but could exacerbate inflationary pressures. However, in an attempt to support liquidity as well as credit to the real sector (particularly exporters), the central bank has increased the limit of export credit refinancing from 15% to 50%, which will potentially release additional liquidity of Rs300bn in the system.

With regards to future guidance, RBI was not very explicit, stating that its future actions will depend on developments in global and domestic economies that may contribute to lowering inflation (such as progress of monsoons, pass-through of international crude oil prices and events in global economy etc). On the liquidity front, however, it was much more forthcoming, stating that it will continue with open market operations (OMOs) to support liquidity.

…focusing on headline inflation rather than demand pressures

Monetary policy action clearly shows that Mint Street is much more concerned about an elevated headline inflation rather than growth slowdown. Indeed, in its policy document, RBI seems to be worried about impact of rising headline inflation on inflation expectation even as the pricing power of corporates/intermediaries is declining.

This clearly shows that RBI is focusing too much on headline inflation (this time, CPI has figured more prominently than in previous policy reviews) and, in their opinion, missing the dynamics at play in the economy. Currently, the economy is operating below potential, corroborated by declining core inflation, lower pricing power of corporates and Q4FY12 GDP numbers, and in such conditions, inflation emanating from supply-side would not translate into generalised inflationary pressures as intermediaries/corporates lack pricing power.

Consequently, in such a scenario, the central bank should focus on core inflation (gauge of demand pressures in the economy) rather than headline inflation, and if the former is declining (as it has been for a while in India), it should cut interest rates to boost the economy and investments.

Indeed, Edelweiss are of the opinion that incrementally, elevated interest rates are actually becoming counter-productive. If the economy is allowed to continue far below its potential, it would start hurting the medium-term growth trajectory. Fiscal deficit would worsen further (as tax revenue falters due to weakening growth), investment slowdown would deepen (hurting medium-term growth trajectory) and inflation could remain sticky (as high interest rates hinder capacity creation). In other words, growth revival is now essential to improve the economy’s overall dynamics. Accordingly, aggressive easing of policy rates to support growth is essential and its timeliness is also important as transmission happens with a lag.

Based on the above, Edelweiss are of the view that RBI should undertake aggressive monetary easing of 75-100bps in the rest of FY13 to support growth and overall dynamics of the economy.

Edelweiss is one of the leading financial services company based in Mumbai, India. Its current businesses include investment banking, securities broking and investment management. They provide a wide range of services to corporations, institutional investors and high net-worth individuals.

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